As I have reported for years regarding Americans’ personal finance concerns, employer-sponsored 401(k) plans are a vital part of one’s retirement savings.
This is particularly important, considering that the average monthly Social Security retirement benefit is only $2,071, according to the Social Security Administration (SSA).
For most people, that is not nearly enough to maintain their desired lifestyle after their careers.
But AARP (the advocacy group for people 50 years of age and older) and financial services firm Fidelity warn Americans that there are some important 401(k) plan details to know.
First, there are consequences for early withdrawals.
“While there are ways to access 401(k) funds ahead of retirement, doing so may come at a cost,” wrote Fidelity. “That includes taxes, early withdrawal penalties, and lost potential growth in a tax-advantaged account.”
“When you withdraw from a 401(k) before age 59-and-a-half, you may owe ordinary income taxes plus a 10 percent penalty, meaning you could lose 25 to 35 percent of what you take out,” said BetterWallet‘s Marc Russell, according to AARP.
“Translation: A $20,000 withdrawal might net you only $12,000 to $14,000 after taxes and penalties,” AARP added.
Fidelity outlines 401(k) drawbacks
All investments accounts involve considerations to keep in mind. Fidelity lists a few others in addition to the early withdrawal penalties.
- Traditional 401(k)s require minimum distributions starting at age 73, even if the account holder does not need the money, and those withdrawals count as taxable income, which can push someone into a higher tax bracket.
- Roth 401(k)s do not require minimum distributions, allowing the money to continue growing tax‑free without mandatory withdrawals.
- Annual contribution limits apply to 401(k) plans, restricting how much an individual can save each year, whereas regular brokerage accounts have no contribution caps even though they lack the same tax advantages.
- All investment accounts carry market risk, meaning the value of investments can decline, although the S&P 500 has historically delivered average annualized returns of about 10%, with the understanding that past performance does not guarantee future results.
- Investment choices in a 401(k) may be limited because employers select the plan’s available options, while IRA holders can choose a provider that offers the specific investment types they want.
- Some 401(k) plans charge administrative and recordkeeping fees in addition to the underlying investment expenses, which can reduce overall returns.
Source: Fidelity
AARP explains 401(k) dilemma many Americans face
One temptation American workers with 401(k) plans find themselves confronting is to use the money they have saved in a retirement account to pay off burdensome credit card debt.
“You look at your 401(k) statement and see a solid balance, just sitting there. Then you look at your credit card bill and see the 20-plus percent interest adding up,” AARP wrote. “You might be tempted to think: Why not use some of those savings to wipe the debt slate clean?”
More on personal finance:
- Zillow forecasts big mortgage change for U.S. housing market
- AARP sounds alarm on major Social Security problem
- Dave Ramsey bluntly warns Americans on 401(k)s
Even though AARP acknowledges that dipping into retirement savings to pay off credit card debt is usually ill-advised, the organization also suggests there are times when a 401(k) loan can make sense.
“Borrowing from a 401(k) is fundamentally different from taking a distribution,” AARP wrote. “Rather than permanently shortchanging your savings, you’re lending yourself money and paying it back — with interest — into your own account.”
“There’s no tax penalty, no credit check and the interest goes to you, not a bank.”
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AARP outlines 401(k) loan scenario
Here’s a situation to consider when thinking about 401(k) loans, according to AARP.
- Carrying $20,000 in credit card debt at a 21% interest rate leads to very slow repayment when making minimum payments of roughly $400 a month, stretching the payoff period to more than a decade.
- Over that repayment horizon, the total interest cost would exceed $29,000, meaning you would pay more in interest than the original balance.
- A 401(k) loan allows you to borrow up to 50% of your vested balance or $50,000, whichever amount is smaller, under IRS rules.
- The interest rate on a 401(k) loan is usually the prime rate plus one or two percentage points, making it significantly lower than typical credit card rates.
- Borrowing $20,000 from a 401(k) at an interest rate of 7.75% and repaying it over five years results in a monthly payment that remains close to $400.
- The total interest paid over that five‑year period would be about $4,200, and every dollar of that interest is deposited back into your own retirement account rather than going to a lender.
Source: AARP
Related: Dave Ramsey sounds alarm on Social Security, 401(k)s
